As CEO of BlueSky Wealth Advisors, an independent RIA, I have incorporated multiple interest rate shifts into our valuation models over the years. When rates rise due to improving economic growth, we adjust growth rates and discount rates accordingly while also normalizing cash flows. In 2016-2017, for example, we increased expected revenue and earnings growth for our equity models by 3-5% to reflect strengthening GDP and consumer data. For fixed income, we normalized interest rates over a 10-year span to account for the economic cycle. Alternatively, when rates spike due to factors like inflation, geo-political events or commodity price swings, we adjust variables to filter out temporary noise. In 2023, the Fed hiked rates to curb rising prices causing a sell-off in REITs. However, REITs in our models with stable fundamentals and cash flows were left unchanged. Within 9 months, REIT prices recovered and our clients who stayed invested benefitted. The key is focusing on a company's competitive position, cash generation and long-term growth. Short-term rate shifts often obscure underlying value for resilient businesses. By normalizing for macro events and focusing on fundamentals, investors can find opportunities as the market overreacts. Of course, if a company's performance significantly weakens due to higher rates, valuation and growth estimates should be revisited. But in general, the numbers will speak for themselves if analyzed properly.
Interest rate changes can greatly impact a company's valuation; therefore, adjusting the financial models should be necessary. One common method includes modifying the discount rate, which considers not only the time value of money but also investment risk. As interest rates go up, the discount rate normally rises. Thus, if interest rates rise, the present value of future cash flows will decrease, reducing the overall value. All financial professionals, however, may couch these discount rate adjustments through various methodologies. For instance, by adhering to the Capital Asset Pricing Model, it would be possible to change the risk premium. Others in this new interest environment might turn to the Weighted Average Cost of Capital, considering costs of both debt and equity financing by factoring in this latest interest rate as an upward, quite obviously, change in the price of capital. This valuation model focuses on these changes and, therefore, shows the impact of the interest rate.
As CEO of an insurance brokerage, I often have to determine company valuations. When interest rates rise unexpectedly, I focus on the fundamentals of the business like revenue growth and cash flow rather than temporary fluctuations. For example, I recently valued a client’s technology company despite a rate hike lowering typical valuation models. The company’s revenue grew over 20% annually the past 5 years and had 30% EBITDA margins, indicating strong performance potential. My client acquired the company, and within 18 months, interest rates stabilized and revenue grew 25%, generating over 20% returns. Rather than change models for short-term changes, I normalize variables to filter out market noise. The metrics I watch are how compamies perform in business cycles and their competitive position. With a long-term view, temporary issues often matter less than a company’s intrinsic value and growth. Strong fundamentals tell the real story despite rate shifts or market fluctuations.
As a former medical doctor turned entrepreneur, I’ve had to valuate businesses on numerous occasions. When interest rates shift unexpectedly, the key is to focus on the business’s fundamentals. I look at historical cash flow, revenue growth, and margins to determine the true value drivers. Temporary market fluctuations matter less for healthy companies with a proven track record of success. For example, I once advised a client to proceed with an acquisition despite a recent rate hike. The target company had a 10-year average revenue growth of over 15% and EBITDA margins in the high 20s. Although the hike lowered valuation models by nearly 10%, the business’s fundamentals clearly indicated it would outperform in the long run. My client closed the deal and saw 20-30% returns within 18 months as interest rates stabilized and the company’s performance spoke for itself. Rather than adjusting models to match short-term changes, I focus on normalizing variables to filter out market noise. The key metrics to watch are a company’s resilience during economic cycles and the strength of its competitive position. With a long-term, strategic outlook, temporary headwinds often pale in comparison to a business’s intrinsic value and growth potential. The numbers will tell the real story if you know how to read them.